It is important to highlight that the surge in optimism fueling the current rise of Tadawul All-Share Index (TASI) is not based wholly on speculative gain or positive sentiment, it is also due to a flourishing Saudi economy, which is underpinned by strong economic fundamentals, according to Jadwa Investment.

The Saudi stock exchange’s trading activity is dominated by local retail investors, says Jadwa’s report titled ‘Opening the Tadawul up to foreign investors’.

The announcement in late July 2014 by the Council of Ministers that foreign investors would be allowed to invest directly in the Tadawul came as no surprise, it said.

The Saudi Arabian index is the region’s most diverse capital market due to its size and maturity, and has been gearing up to welcome foreign investors for some time now.

Although foreign investors have been able to access the Tadawul through indirect routes, via swaps and exchange-traded funds, allowing direct foreign ownership will be a key milestone for the development of Saudi Arabian capital markets and indeed the wider economy.

Jadwa Investment says it views the opening up of the Tadawul as an overall positive but we believe a cautious and considered path to reform is the best way forward, much like the Chinese example.

According to the draft proposals released by the Capital Markets Authority (CMA) any Qualified Foreign Investor (QFI) wanting to participate in the Saudi stock exchange will have to have at least $5 billion assets under management (AUM) (possibly reduced to $3 billion) and have been operational for a minimum of 5 years. Other limitations apply, including:

* Each QFI (including affiliates) can only hold a maximum of 5 percent of issued shares of any one listed company.

* All foreign investors (including resident and non-resident, swaps and QFI’s) have a combined ceiling of 49 percent ownership of issued shares, in any one listed company.

*  QFI’s together can only own a maximum of 20 percent of issued shares of any one listed company.

* Swaps and QFI’s can only own up to a maximum of 10 percent of aggregate stock market value of all listed companies.

The opening and eventual inclusion of the Tadawul into MSCI raises the risks of over pricing of stocks in the short to medium term.

With the greater dominance of retail investors and their higher risk appetite, there is a strong possibility that the Tadawul could move beyond fair value levels.

With the Saudi stock exchange expected to be included into the MSCI Emerging Markets Index by 2017, a similar pattern of events could occur to what was seen in Qatar and the UAE.

Both countries stock markets rose before the inclusion of the respective indices, in early June 2014, into the MSCI Emerging Markets Index, and then dipped immediately after.

Qatar’s benchmark QE Index advanced to five year highs in early June 2014 and then dropped, whilst shares on the Dubai Financial Market General Index dropped by 22 percent by the end of June 2014.

According to the Jadwa report, there are already signs that the Tadawul All Share Index is moving toward being over heated, having risen over 10 percent since the announcement on July 21.

Furthermore, current price/earnings (PE) valuations are trending above the long term average, with PE at 20.4 in early August, although it still below previous peaks of 27.4, in mid-2006.